Comments on: Realistic Rate of Return – Part IV Inflation http://myfinancialjourney.com/archive/realistic-rate-of-return-part-iv-inflation Mon, 26 Jul 2010 18:42:01 +0000 hourly 1 http://wordpress.org/?v=3.0 By: mathdude http://myfinancialjourney.com/archive/realistic-rate-of-return-part-iv-inflation/comment-page-1#comment-196 mathdude Thu, 01 Feb 2007 13:58:06 +0000 http://www.myfinancialjourney.survivingkids.com/archive/realistic-rate-of-return-part-iv-inflation#comment-196 Another thing to consider is that although the arithmetic mean annual return is usually calculated as "expected return", the correct calculation is really the geometric mean. For example, if one year your returns were 15% and the next year your returns were 1%, the expected return as normally calculated is 8% or 1.08, but the real expected return is sqrt(1.15*1.01) =1.0777 or 7.77%. This may seem insignificant, but the arithmetic mean is ALWAYS smaller than the geometric mean, and from 1965 to 2006, the average annual return was 1.090788 but the geometric mean of the annual returns is 1.080915. This may seem insignificant, but $1 invested in 1950 in the S&P would be about $84, but the calculation based on "average annual return" would be $141 ... a 67% overshoot. As an exercise, take the annual returns over any period of time, and calculate normally the amount of money you'd make (i.e. rate^(#years). Now, divide the real end price by the real start price and see the difference. Another thing to consider is that although the arithmetic mean annual return is usually calculated as “expected return”, the correct calculation is really the geometric mean. For example, if one year your returns were 15% and the next year your returns were 1%, the expected return as normally calculated is 8% or 1.08, but the real expected return is sqrt(1.15*1.01) =1.0777 or 7.77%. This may seem insignificant, but the arithmetic mean is ALWAYS smaller than the geometric mean, and from 1965 to 2006, the average annual return was 1.090788 but the geometric mean of the annual returns is 1.080915. This may seem insignificant, but $1 invested in 1950 in the S&P would be about $84, but the calculation based on “average annual return” would be $141 … a 67% overshoot.

As an exercise, take the annual returns over any period of time, and calculate normally the amount of money you’d make (i.e. rate^(#years). Now, divide the real end price by the real start price and see the difference.

]]> By: traineeinvestor http://myfinancialjourney.com/archive/realistic-rate-of-return-part-iv-inflation/comment-page-1#comment-194 traineeinvestor Tue, 16 Jan 2007 01:37:30 +0000 http://www.myfinancialjourney.survivingkids.com/archive/realistic-rate-of-return-part-iv-inflation#comment-194 Inflation can really play havoc with longer term financial plans - even at realtively low official rates like 2 or 3% (assuming the official rates represent the true rate of inflation which I doubt). Great way of illustrating the point. US$2.5 million may sound like a huge amount of money today, but it may well be insufficient by the time retirement arrives. Inflation can really play havoc with longer term financial plans – even at realtively low official rates like 2 or 3% (assuming the official rates represent the true rate of inflation which I doubt).

Great way of illustrating the point. US$2.5 million may sound like a huge amount of money today, but it may well be insufficient by the time retirement arrives.

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